When you save for retirement, you have two big-picture options: taxable accounts and tax-advantaged accounts. However, within the tax-advantaged bucket, there are also two variations, pre-tax and post-tax accounts. In the end, you'll likely have three different retirement savings buckets to consider as you look to pay your living costs in retirement. You'll want to choose wisely between them.
Taxes matter when it comes to retirement accounts
A taxable account is basically just a traditional brokerage account. That doesn't work any differently in retirement than it does before you stop working. You have to pay taxes on the interest, dividends, and capital gains you collect. However, you can use the money as you see fit without further tax considerations.
Tax-advantaged accounts are more complicated. Traditional 401(k) accounts and Traditional Individual Retirement Accounts (IRAs) are funded with pre-tax money. Since you avoid taxes when you fund the account, every cent you pull out is taxable. Roth 401(k) and Roth IRA accounts are funded with post-tax money. Since you pay taxes on the money going in, you don't pay any tax on the money you take out.
These facts change the way you need to think about the accounts you use to supplement Social Security in retirement.
Image source: Getty Images.
Don't get stuck with huge RMDs
The big problem comes from Traditional IRAs and 401(k)s: after you reach age 73, the government forces you to start withdrawing money from these pre-tax-funded accounts. That means you will have income that could change your financial picture, leading to taxes and even reducing some benefits you collect. If you hold off on drawing from your Traditional 401(k) or Traditional IRA it may continue to grow to the point where your RMDs are substantial. Once you hit retirement, you'll likely want to start pulling money from this type of account before you use money from your Roth accounts and taxable accounts. That way, you can spread the tax impact over time.
The last accounts you'll want to touch are your Roth accounts, since withdrawals don't trigger any taxes. It doesn't matter how large these accounts get, and there are no RMD requirements, either. So there's no harm in leaving your savings in these accounts to grow.
The wildcard is your taxable accounts. Selling assets will trigger capital gains taxes, which is an issue to consider. However, you can tap this cash anytime you want. So, if you are lucky enough to retire before the point where you can access an IRA or 401(k) for cash without penalty, your taxable account is the first one you'll want to use so you can avoid early withdrawal penalties. And once you start pulling from tax-advantaged retirement accounts, your taxable account can help you hold off on touching your Roth accounts, allowing them to continue their tax-advantaged growth.
Thinking ahead can save you a lot of headaches
So, when all is said and done, the basic order for most people will be taxable accounts if you retire early, Traditional 401(k) and Traditional IRA accounts once you can use them without early withdrawal penalties, and then Roth accounts. If you wait too long to tap your Traditional 401(k) or Traditional IRA, you may find that you end up hurting yourself financially in the long run when RMDs kick in.
